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June 20, 2014

A Fresh Look at Portfolio Construction: Setting Goals With the Client

This is the second in a series of blogs meant to take a new look at how advisors build portfolios for clients. In the first posting, we argued that advisors must use a consistent and measurable “risk-based approach” when analyzing portfolios and investment strategies and making any specific security recommendations to clients.

In this posting, we argue that developing successful investment strategies and competing for investment capital depends on the advisor’s ability to demonstrate to prospective clients that they have a clear and rational method for developing and implementing investment plans. There are three distinct steps for doing so.

Step 1: Establishing the Risk Profile

The first step is to determine the prospect’s Risk Profile, to determine how much downside risk is acceptable.

A review of the current portfolio’s risk characteristics with the client should give you and the investor a good idea of how much risk he is willing to take. Do not be generic in specifying this risk (i.e., growth and income, or aggressive): risk is a function of how much loss of principal (real or nominal) the client is willing to accept in any 12-month period. In general, assuming a balanced portfolio, risk levels should never exceed -12.50% (minimum ROR) in any twelve-month period.

It is imperative that you have a quantitative answer to this risk profile since it is intrinsically tied to any investment solution you will develop. For example, you might establish a set of reasonable investment objectives and the range of risk associated with each as follows.

Investment Objective

Risk Tolerance Range

Default Risk Value

Capital Preservation

risk tolerance range of 0.00% ... -1.75% (default of 1.00%)

-1.00%

Income

risk tolerance range of -1.75% ... -4.25% (default of -3.00%)

-3.00%

Growth & Income

risk tolerance range of -4.25% ... -6.75% (default of –5.25%)

-5.25%

Growth

risk tolerance range of -6.75% ... -10.25% (default of –8.50%)

-8.50%

Aggressive Growth

risk tolerance range of -10.25% ... -12.75% (default of –11.50%)

-11.50%

From a marketing stand point, there are very few investors who would not pay to know how much risk they are currently taking with their portfolio and what kind of performance might be expected. Managing the investor’s risk and expected performance are critical in providing sound financial advice.

Some years ago I was working with an $86 million pension fund in Chicago that wanted to know what level of risk and return they might expect from their current mix of investments. The analysis demonstrated that, within the 90% probability range, they had a risk of losing 9.6% of their principal in any twelve-month period. Clearly, this was much greater risk than they were comfortable with from an actuarial and funding perspective. Understanding this, we were able to then design a portfolio that was more compatible with their risk profile.

Step 2: Analyzing Current Investments

Once the Risk Profile has been established, the next step is to review and analyze the risk and performance characteristics of existing investments to determine if they exhibit more or less risk and performance than expected.

It is virtually impossible to know how to achieve your objectives unless you know where you’re starting from.

The process begins by using a sophisticated analytical tool to determine the portfolio’s return, standard deviation (a measure of volatility), diversification (correlation matrix) and probable range of returns (upper and lower boundaries). Other metrics of value for consideration include: Sharpe Ratio, Treynor Ratio, Sterling Ratio, cumulative rate of return, alpha, beta, R-square, maximum drawdown, up and down market capture, overlap analysis, equity and fixed income properties. These metrics will help you and the client better understand the true performance of the portfolio and its constituent parts.

The lower boundary of acceptable risk (the investor’s risk tolerance) is determined by first calculating the historical mean or annualized rate of return and standard deviation of the portfolio. Using that information we can easily determine the upper and lower boundaries of return at any specified probability level. In most cases you will use the 90% probability value. A lower boundary that is greater than the prospect’s Risk Profile (i.e., 12.5% compared to a Risk Profile of -5.0%) indicates that the portfolio is riskier than desired.

At the 90% level:

Upper boundary = 1.654 * STD + Mean ROR

Lower boundary = 1.654 * STD - Mean ROR

The lower the asset standard deviations and the greater the degree of negative correlation, the lower the portfolio risk will be.

Metrics indicating that the current portfolio exhibits excessive risk and is underperforming:

Downside risk/Lower Boundary is greater than established in the investor’s Risk Profile indicates that the portfolio is too risky.

Maximum Drawdown is high indicating excessive volatility.

Sharpe Ratio is low (under 0.80) indicates that the portfolio is very inefficient (poor asset allocation).

Correlations are low indicating poor asset/security selection.

Metrics alone will not tell you if a portfolio is too volatile or underperforming. An asset with a higher standard deviation may not indicate greater volatility since a higher rate of return might reflect greater incremental return per unit of change in standard deviation. Establish a set of metrics that you can consistently use to review the risk/return characteristics of the portfolio and its relationship to the investor’s Risk Profile.

Step 3: Financial Objectives (Goal Setting)

In general, the primary objective for any investment portfolio is to provide sufficient capital and income for the investor to live “comfortably” in post-retirement years. Evaluating the success of your scenario could include Monte Carlo simulations and/or straight-line cash flow analysis using estimated returns and standard deviations.

While it is not necessary to have a detailed estate plan in place for most investors, nonetheless it is important that some objectives are clearly set out and that the probability of achieving those goals is evaluated by your portfolio analytical tools. You will require a sophisticated analytical tool that will establish clear financial objectives and quickly determine if the current or proposed portfolios are likely to achieve those objectives.

What financial goals does the investor want to achieve (retirement, college, major purchases, etc.)?

What is the start and end date of each goal?

How much risk is the investor willing to accept to achieve each goal?

How much money can he invest towards the goals now and in the future?

How much money will be needed to achieve the goals based on expected return?

Goal

WithdrawalContribution

Amount

MonthlyQuarterlyAnnually

Inflation%

Begin Date

End Date

College

Withdrawal

$20,000

Annually

4.5%

9/2015

6/2019

Summing Up

Most individual investors acquire assets without much, if any, consideration given to their financial objectives, expected portfolio rates of return, risk, and the inter-relationship or balance of the assets involved.They generally end up with a mix of unrelated investments which, as a whole, can never fulfill the investor's policies and objectives. Advisors need to design portfolios that will achieve financial objectives by matching assets according to risk/return trade-offs. If capital is allocated efficiently, portfolio returns will generally be higher over the long-term, and portfolio volatility will be lower.

In the third and final installment, we will discuss portfolio construction and asset class suitability; designing the proposed portfolio including forecasting performance and optimizing portfolios; finding appropriate investment vehicles; and achieving established financial goals.